Chapter Five

Fundamental Concepts of Macroeconomics

Introduction

Conventionally, economics is divided into microeconomics and macroeconomics.

Microeconomics studies about the individual decision making behavior of different economic
units such as households, firms, and government at a disaggregated level. Whereas,
macroeconomics, studies about overall or aggregate behavior of the economy, such as economic
growth, employment, inflation, distribution of income, macroeconomic policies and
international trade.
This chapter discusses major macroeconomic issues such as measurement of a country‘s
economic performance, macroeconomic problems (fluctuations in economic system mainly
reflected by inflation and unemployment), how budgetary deficit and trade deficit occur and
macroeconomic policies applied to cure the macroeconomic problems.

5.1. GOALS OF MACROECONOMICS

Macroeconomics studies the working of an economy in aggregation or as a whole. And it aimed
at how;
 To achieve high economicgrowth
 To reduceunemployment
 To attain stableprices
 To reduce budget deficit and balance of payment (BoP)deficit
 To ensure fair distribution ofincome
In other words, the goals of macroeconomics can be given as ways towards full employment,
price stability, economic growth and fair distribution of income among citizens of a country.

5.2. THE NATIONAL INCOMEACCOUNTING

National Income Accounting (NIA) is an accounting record of the level of economic activities
of an economy. It is a measure of an aggregate output, income and expenditure in an economy.

Why do we need to study NIA?

 It enables us to measure the level of total output in a given period of time, and to explain the
causes for such level ofperformance.
 It enables us to observe the long run trend of theeconomy.
 It provides information to formulate policies and designplans.

APPROACHES TO MEASURE NATIONAL INCOME (GDP/GNP)

Before discussing different approaches of national income, it is important to understand about
the measure of the economic performance of a given country at large. Generally it is named as
GDP or GNP.
Gross Domestic Product (GDP): it is the total value of currently produced final goods and
services that are produced within a country‘s boundary during a given period of time, usually
one year. From this definition, we can infer that:
 It measures the current production only.
 It takes in to account final goods and services only (only the end products of various
production processes) or we do not include the intermediate products in our GDP

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 calculations. Intermediate goods are goods that are completely used up in the production
of other products in the same period that they themselves areproduced.
 It measures the values of final goods and services produced within the
boundary/territory of a country irrespective of who owns thatoutput.
 In measuringGDP, wetakethe market values ofgoods and services(GDP= ƩPiQi)
Where:
o Pi = series of prices of outputs produced in different sectors of an economy in
certainperiod
o Qi = the quantity of various final goods and services produced in aneconomy

Gross National Product (GNP): is the total value of final goods and services currently
produced by domestically owned factors of production in a given period of time, usually one
year, irrespective of their geographical locations.
GDP and GNP are related as follows:
GNP=GDP + NFI

NFI denotes Net Factor Income received from abroad which is equal to factor income received
from abroad by a country‘s citizens less factor income paid for foreigners to abroad. Thus,
NFI could be negative, positive or zero depending on the amount of factor income received by
the twoparties.
 If NFI >0, then GNP >GDP
 If NFI<0, then GNP <GDP
 If NFI =0, then GNP=GDP

Basically, there are three approaches to measure GDP/GNP. These are:

I. Product/value added approach,
II. Expenditure approach and
III. Incomeapproach

i. Product Approach
In this approach, GDP is calculated by adding the market value of goods and services currently
produced by each sector of the economy. In this case, GDP includes only the values of final
goods and services in order to avoid double counting.Double counting will arise when the
output of some firms are used as intermediate inputs of other firms. For example, we would not
include the full price of an automobile in GDP and then also include as part of GDP the value of
the tires that were sold to the automobile producer. The components of the car that are sold to
the manufacturers are called intermediate goods, and their value is not included in GDP.

There are two possible ways of avoiding double counting.

 Taking only the value of final goods andservices
 Taking the sum of the valued added by all firms at each stage of
production

We can illustrate the two scenarios using some hypothetical examples asfollows.

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 I. Taking only the value of final goods andservices
Example:
Sectors Value of Output (in million birr)
1. Agriculture and allied activities 9,309
- Agriculture 7000
- Forestry 1000
- Fishing 1309
2. Industry 147,413
- Mining & quarrying 9842
- Large & medium scale manufacturing 91852
- Electricity & water 13717
- Construction 32002
3. Service 357, 872
- Banking insurance and real estate 121704
- Public administration & defense 36605
- Health 20000
- Education 32509
- Domestic & other services 147054
4. Net factor income from abroad 87,348

GDP = 9,309+147,413+357,872 = 514,594

GNP = GDP + NFI = 514,594 +87,348 = 601,942

II. Taking the sum of the valued added by all firms at each stage of
production Example:
Stages of production Values of output Cost of intermediate Value added
(in birr) inputs
Farmer 500 0 500
Oil factory 2000 500 1500
Retailers 2500 2000 500

Note: If all values in the economy were added, GDP would be 5000= (2500+2500). The
problem of double counting is 2500, because of considering intermediate input in the
calculation.

ii. Expenditure Approach

Here GDP is measured by adding all expenditures on final goods and services produced in the
country by all sectors of the economy. Thus, GDP can be estimated by summing up personal
consumption of households (C), gross private domestic investment (I), government purchases
of goods and services (G) and net exports (NE).
 Personal consumption expenditure: includes expenditures by households on durable
consumer goods (automobiles, refrigerators, video recorders, etc.), non-durable consumer
goods (clothes, shoes, pens, etc.) and services.
 Gross private domestic investment:is defined as the sum of all spending of firms on plants,
equipment, and inventories, and the spending of households on new houses. Investment is
broken down into three categories: residential investment (the spending of households on the
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 construction of new houses), business fixed investment (the spending of firms on buildings
and equipment for business use), and inventory investment (the change in inventories of
firms).
 Government purchases of goods and services: include all government spending on finished
products and direct purchases of resources less government transfer payments because
transfer payments do not reflect current production although they are part of government
expenditure.
 Net exports: refer to total value of exports less total value of imports. Note that net export is
different from the terms of trade in that the latter refers to the ratio of the value of exports to
the value of imports.

Example: GDP at current market price measured using expenditure approach for a hypothetical
economy.
Types of expenditure Amount (in million Birr)
1. Personal consumption expenditure 4,500
Durable consumer goods 1500
Non-durable consumer goods 2000
Services 1000
2. Gross private domestic investment 600
Business fixed investment 250
Construction Expenditure 300
Increases in inventories 50
3. Government expenditure on goods and services 250
Federal government 100
State government 150
4. Net export -50
Exports 150
Imports 200
GDP at current market price 5,300

iii. Income Approach

In this approach, GDP is calculated by adding all the incomes accruing to all factors of
production used in producing the national output. It is crucial, however, to note that some forms
of personal incomes are not incorporated in the national income. For instance, transfer payments
(payments which are made to the recipients who have not contributed to the production of
current goods and services in exchange for these payments) are excluded from national income,
as these are mere redistribution of income from taxpayers to the recipients of transfer payments.
Transfer payments may take the form of old age pension, unemployment benefit,
subsidies,etc.According to this approach, GDP is the sum incomes to owners of factors of
production plus some other claims on the value of output (depreciation and indirect business
tax) less subsidies and transfer payments.
GDP = Compensation of employees (wages &salaries)+ Rental income+ Interest income
+ Profits (proprietors’ profit plus corporate profit)+ indirect business taxes+ Depreciation –
Subsidies–Transferpayments

Example:
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 Items Value (in million Birr)
1) Compensation of Employees 45623.71
2) Rental Income 1249.32
3) Proprietor‘s Income 10561.21
4) Corporate Profits 16960.33
Subtotal (corporate and proprietor‘s) 27521.54
5) Net interest 5189.73
6) Depreciation 503.84
7) Indirect Business Taxes 476.51
8) Subsidy (11368.95)
Gross Domestic Product 69195.70
9) Income from abroad 2036.20
10) Payments to abroad (11231.90)
NFI (9195.70)
Gross National Income 60000.00

Limitation of GDP measurement:

The calculation of national income is not an easy task. We face a number of problems in the
estimation of national income, especially in under-developed countries like Ethiopia.
 Definition of a nation: while calculating national income, nation does not mean only the
political or geographical boundaries of a country for calculating the value of final goods
and services produced in the country. It includes income earned by the nationalsabroad.
 Stages of economic activities: it is also difficult to determine the stages of economic
activity at which the national income is determined i.e. whether the income should be
calculated at the stage of production or distribution or consumption. It has, therefore,
been agreed that the stage of economic activity may be decided by the objective for
which the national income is being calculated. If the objective is to measure economic
progress, then the production stage can be considered. To measure the welfare of the
people, then the consumption stage should be taken intoconsideration.
 Transfer payments: this also creates a great difficulty in calculating the national income.
It has generally been agreed that the best way is to consider only the disposal income of
the individuals ofgroups.
 Underground economy: no imputation is made for the value of goods and services sold
in the illegal market. The underground economy is the part of the economy that people
hide from the government either because they wish to evade taxation or because the
activity is illegal. The parallel exchange rate market is oneexample.
 Inadequate data: in all most all the countries, difficulty has been faced in the calculation
of national income due to lack of adequate data. Sometimes, the data are notreliable.
 Non-monetized sector: this difficulty is special to developing countries where a
substantial portion of the total produce is not brought to the market for sale. It is either
retained for self-consumption or exchanged for other goods andservices.
 Valuation of depreciation: the value of depreciation is deducted from the gross national
product to get net national product. But the valuation of such depreciation is full of
difficulties.
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  Changes in price levels: since the national income is in terms of money whose value
itself keeps on changing, it is difficult to make a stable calculation which is assessed in
terms of prices of the baseyear.
 No focus on quality: it is difficult to account correctly for improvements in the quality of
goods. This has been the case for computers, whose quality has improved dramatically
while their price has fallen sharply. It also applies to other goods such as cars whose
quality changes overtime.

OTHER INCOMEACCOUNTS
Apart from GDP and GNP, there are also other social accounts which have equal importance in
macroeconomic analysis. These are:
 Net National Product(NNP)
 National Income(NI)
 Personal Income(PI)
 Personal Disposable Income (PDI)

Net National product (NNP) : GNP as a measure of the economy‘s annual output may have
defect because it fails to take into account capital consumption allowance, which is necessary to
replace the capital goods used up in that year‘s production. Hence, net national product is a
more accurate measure of economy‘s annual output than gross national product and it is given
as:

Net National product =Gross National product – Capital consumption allowance

(NNP)(GNP)(D)

National income (NI): National income is the income earned by economic resource (input)
suppliers for their contributions of land, labor, capital and entrepreneurial ability, which are
involved in the given year‘s production activity. However, from the components of NNP,
indirect business tax, which is collected by the government, does not reflect the productive
contributions of economic resources because government contributes nothing directly to the
production in return to the indirect business tax. Hence, to get the national income, we must
subtract indirect business tax from net national product.

National Income = Net National Product – Indirect Business Tax (NI)(NNP)(IBT)

Personal Income (PI): refers to income earned by persons or households. Persons in the
economy may not earn all the income earned as national income.

PI = NIDisposable
Personal – [social security
Income:contribution + corporate
it is personal income
income less tax +tax
personal retained corporate profit]
payments.
DI = PI – Personal
+ [Public taxes
transfer payments (e.g. Subsidy) + net interest on government bond]
DI = C + S where, C = personal consumption expenditure, S = Personal savings

5.3. NOMINAL VERSUS REALGDP

 Nominal GDP is the value of all final goods and services produced in a given year when
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 valued at the prices of that year. That is, nominal GDP = where, P is the general price level
and Q is the quantity of final goods and services produced. Therefore, any change that can
happen in the country‘s GDP is due to changes in price, quantity or both. For example, if
prices are doubled over one year, then GDP will also double even though exactly the same
goods and services are produced as the year before. Hence, GDP that is not adjusted for
inflation is called Nominal GDP.
 Real GDP is the value of final goods and services produced in a given year when valued at
the prices of a reference base year. By comparing the value of production in the two years at
the same prices, we reveal the change in output. Hence, to be able to make reasonable
comparisons of GDP overtime we must adjust for inflation.

Example: Consider an economy producing two goods, X and Y.

Year Product Quantity Unit price ($)

2017 X 20 5
(base year) Y 8 50
2018 X 25 20
Y 10 100

Given the above information, we can calculate the real and nominal GDP in both years as
follows:
In 2017: In 2018:
Nominal GDP
5.4. THE = (20
GDP x 5) + (8 x AND
DEFLATOR 50) = THE
$500 CONSUMER
The outputs of 2018 valued at(CPI)
PRICEINDEX the prices of
Real GDP = (20 x 5) + (8 x 50) = $500 2017(the base year).
The GDP Deflator: The calculation of
Note that both the real and nominal GDP real GDP gives us a useful measure of inflation known
Nominal GDP= (25 x 20) + (10 x 100) =
as the GDP deflator. The GDP deflator is the ratio of nominal GDP in a given year to real GDP
values are exactly the same in the base $1500
of that year. It reflects what‘s happening to the overall level of prices in the economy.
year. Real GDP = (25 x 5) + (10 x 50) = $625

GDP deflator =

We can calculate the GDP deflator based on the example above.

GDP deflator (2017) = 500/500 = 1x100 = 100

As both the real and nominal GDP values are exactly the same, the GDP deflator

GDP deflator (2018) = 1500/625 = 2.4x100 = 240, which shows the price in 2018

was 140% higher than the price in base year.

The Consumer Price Index: The Consumer Price Index (CPI) is an indicator that measures the
average change in prices paid by consumers for a representative basket of goods and services. It
compares the current and base year cost of a basket of goods of fixed composition. If we denote

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 the base year quantities of the various goods by q'0 and their base year prices by р'0, the cost of
the basket in the base year is ∑р'0*q'0, where the summation is over all the goods in the basket.
The cost of a basket of the same quantities but at today's prices is ∑p' t,q'0, where pt is today's
price. The CPI is the ratio of today's cost to the base year cost.
CPI= ∑p't,q'0
∑р'0*q'0

The CPI versus the GDP Deflator

The GDP deflator and the CPI give somewhat different information about what‘s happening to
the overall level of prices in the economy. There are three key differences between the two
measures.
1) GDP deflator measures the prices of all goods and services produced, whereas the CPI
measures the prices of only the goods and services bought by consumers. Thus, an
increase in the price of goods bought by firms or the government will show up in the
GDP deflator but not in theCPI.
2) GDP deflator includes only those goods produced domestically. Imported goods are not
part of GDP and do not show up in the GDPdeflator.
3) The CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator
assigns changing weights. In other words, the CPI is computed using a fixed basket of
goods, whereas the GDP deflator allows the basket of goods to change over time as the
composition of GDPchanges.

5.5. THE BUSINESSCYCLE

Business cycle refers to the recurrent ups and downs in the level of economic activity.
Countries usually experience ups and downs in the level of total output and employment over
time. For some period of time the total output level may increase and other times it may decline.

With the fluctuation in the overall economic activity, the level of unemployment also moves up
anddown.
Growth trend

Level of
Business
Output
cycle
Boom/pea
k
Trough/
Depression
Boom/peak
Expansio
Recessi

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Time
 Figure 6.9: The business cycle

A business cycle is a fluctuation in overall economic activity, which is characterized by the

simultaneous expansion or contraction of output in most sectors. We can identify four phases in
the business cycle.
Boom/peak: it is a phase in which the economy is producing the highest level of output in the
business cycle. It is the point which marks the end of economic expansion and the beginning of
recession. In this phase, the economy‘s output is growing faster than its long-term (potential)
trend and is therefore unsustainable. Due to very high degree of utilization of resources,
unemployment level is low; business is good; and it is a period of prosperity.

Recession/contraction: during a recession phase, the level of economic performance generally

declines. Total output declines, national income falls, and business generally decline. As a
result, unemployment problem rises. When the recession becomes particularly severe, we say
the economy reaches depression or trough. This period can cause hardship on business and
citizens.
Trough/Depression: - this phase is the lowest point in a business cycle. It marks the end of a
recession and the beginning of economic recovery/expansion. During this period, there is an
excessive amount of unemployment and idle productive capacity.
Recovery/Expansion: - during this phase, the economy starts to grow or recover, i.e. there is an
option of economic activity between a trough and a peak. In this phase, more and more
resources are employed in the production process; output increases, unemployment level
diminishes and national income rises. When this expansion of the economy reaches its
maximum, the economy once again comes to another boom orpeak.

Note that:
 One business cycle includes the point from one peak to the next peak or from one troughto
the next.
 A business cycle is a short-term fluctuation in economicactivities.
 The trend path of GDP is the path GDP would take if factors of production were fully
employed.
 Business cycles may vary in duration andintensity.

5.6. MACROECONOMIC PROBLEMS

5.6.1. UNEMPLOYMENT
Unemployment: refers to group of people who are in a specified age (labor force), who are
without a job but are actively searching for a job. In the Ethiopia context, the specified age is
between 14 and 60 which are normally named as productive population. To better understand
what unemployment is, it is important to begin with classifying the whole population of a
country into two major groups: those in the labor force and those outside the labor force.

Labor force: includes group of people within a specified age (for instance, people whose ages
are greater than 14 are considered as job seekers though formal employment requires a
minimum of 18 years of age bracket) who are actually employed and those who are without a
job but are actively searching for a job, according to the Ethiopian labor law. Therefore, the
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labor force does not include: Children <14 and retired people age >60, and also people in
mental and correctional institutions, and very sick and disabled people etc. A person in the labor
force is said to be unemployed if he/she is without a job but is actively searching for a job.

TYPES OF UNEMPLOYMENT
Labor force = Employed + Unemployed

1. Frictional unemployment: refers to a brief period of unemployment experienced due to:

 Seasonality of work E.g. Constructionworkers
 Voluntary switching of jobs in search of betterjobs
 Entrance to the labor force E.g. A student immediately aftergraduation
 Re-entering to the laborforce
2. Structural unemployment: results from mismatch between the skills or locations of job
seekers and the requirements or locations of the vacancies. E.g. An agricultural graduate
looking or a job atPiassa. The causescould be change in demandpattern or
technologicalchange.
3. Cyclical unemployment:results due to absence of vacancies. This usually happens due to
deficiency in demand for commodities/ the low performance of the economy to createjobs.
E.g. During recession
Note:Frictional and structural unemployment are more or less unavoidable; hence, they are
known as natural level of unemployment.

Measurement of rates of unemployment

Total unemployment = Frictional + Structural + Cyclicalunemployment
Natural level of unemployment = Frictional unemployment + Structural unemployment
= Total unemployment - Cyclical unemployment
Natural rate of unemployment = Natural unemployment /labor force
Unemployment rate = total unemployment / labor force

When the unemployment rate is equal to the natural rate of unemployment, we say the economy
is at full employment. Therefore, full employment does not mean zero unemployment.
5.6.2. INFLATION
It is the sustainable increase in the general or average price levels commodities. Two points
about this definition need emphasis. First, the increase price must be a sustained one, and it is
not simply once time increase in prices. Second, it must be the general level of prices, which is
rising; increase in individual prices, which can be offset by fall in prices of other goods is not
considered as inflation.

Causes of inflation
The causes of inflation are generally classified into two major groups: demand pull and cost
push inflation.
A. Demand pull inflation: according to demand pull theory of inflation, inflation results
from a rapid increase in demand for goods and services than supply of goods and
services. This isa situation where ―too much money chases too few goods.‖
B. Cost push or supply side inflation: it arises due to continuous decline in aggregate
supply. This may be due to bad weather, increase in wage, or the prices of otherinputs.

Economic effects of inflation

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 1. Generally inflation reduces real money balance or purchasing power of money. This will
in turn reduce the welfare ofindividuals.
2. Banks charge their customers nominal interest rate for their loans. Nominal interest rate
however is determined based on inflation rate as it is represented by Fisher‘s equation, I=
r+П where, I is nominal interest rate, r is real interest rate and П is inflation rate.
Increase in inflation rate will raise the nominal interest rate and the opportunity cost of holding
money. If people are to hold lower money balances on average, they must make more frequent
trips to the bank to withdraw money. This is metaphorically called the shoe-leather cost of
inflation.
3. Inflation reduces investment by increasing nominal interest rate and creating uncertainty
about macroeconomicpolicies.
4. Inflation redistributes wealth among individuals. Most loan agreements specify a nominal
interest rate, which is based on the rate of inflation expected at the time of the agreement.
If inflation turns out to be higher than expected, the debtor wins and the creditor loses
becausethedebtorrepaystheloanwithlessvaluabledollars.Ifinflationturnsouttobelower than
expected, the creditor wins and the debtor loses because the repayment is worth more than the
two parties anticipated.
5. Unanticipated inflation hurts individuals with fixed income andpension.
6. High inflation is always associated with variability of prices which induces firms to
change their price list more frequently and requires printing and distributing new
catalogue. This is known as menu cost ofinflation.

5.6.3. TRADE AND BUDGET

DEFICIT

1. BUDGETDEFICIT
The overriding objectives of the government‘s fiscal policy are building prudent public financial
management, financing the required expenditure with available resource and refrain from
possibility of unsustainable fiscal deficit.The government receives revenue from taxes and uses
it to pay for government purchases. Any excess of tax revenue over government spending is
called public saving, which can be either positive (a budget surplus) or negative (a budget
deficit).

When a government spends more than it collects in taxes, it faces a budget deficit, which it
finances by borrowing from internal and external borrowing. The accumulation of past
borrowing is the government debt. Debate about the appropriate amount of government debt in
the United Statesis as old as the country itself. Alexander Hamilton believed that ―a national
debt, if it is not excessive, will be to us a national blessing,‖ while James Madison argued that
―apublicdebt is apubliccurse‖.

When we see Ethiopian case, to augment available domestic financing options, the government
opted to finance its fiscal deficit from external sources on concessional terms. In particular, the
Government of Ethiopia finances its budget by accessing external loans on concessional terms.
As a rule of thumb, non-concessional loans cannot be used to finance the budgetary activities.
On the other hand, external non-concessional loans are used to finance projects that are run by
State Owned Enterprises. In recent years, the government accessed loans from international
market on non-concessional terms to finance feasible and profitable projects managed by State
Owned Enterprises (SOEs). The country‘s total public debt contains central government,
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government guaranteed and public enterprises.

2. TRADE DEFICIT
The national income accounts identity shows that net capital outflow always equals the trade
balance. Mathematically,
S −I = NX.
Net Capital Outflow = Trade Balance
Net cash out flow is Saving(S) – Investment (I)
Balance of Trade = Merchandize Exports – Merchandize Imports

 If this balance between S − I and NX is positive, we have a trade surplus, so we say that
there is a surplus in the current account. In this case, we are net lenders in world
financial markets, and we are exporting more goods than we areimporting.
 If the balance between S − I and NX is negative, we have a trade deficit then we say
that there is a deficit in the current account. In this case, we are net borrowers in world
financial markets, and we are importing more goods than we areexporting.
 If S − I and NX are exactly zero, we are said to have balanced trade because the value
of imports equals the value ofexports.

5.7. MACROECONOMIC POLICYINSTRUMENTS

The ultimate policy objective of any country in general is to have sustainable economic growth
and development. Policy measures are geared at achieving moderate inflation rate, keeping
unemployment rate low, balancing foreign trade, stabilizing exchange and interest rates, etc and
in general attaining stable and well-functioning macroeconomic environment.

5.7.1. MONETARYPOLICY
Monetary policy refers to the adoption of suitable policy regarding the control of money supply
and the management of credit which is important measure for adjusting aggregate demand to
control inflation. It is concerned with the money supply, lending rates and interest rates and is
often administered by a central bank.Monetary policy is a highly flexible stabilization policy
tool. For instance, during economic recession where output falls with a fall in aggregate
demand, monetary policy aims at increasing demand and hence production as well as
employment will follow the same pattern of demand. In contrast, at the time of economic boom
where demand exceeds production and treat to create inflation, the monetary policy instruments
are utilized that could offset the condition and achieve price stability by counter cyclical action
upon moneysupply.
Government monetary policy regulation is under responsibilities of Central Banks. Central
Bank controls the money supply to control nominal interest rates. Investment and saving
decisions are based on the real interest rate. When government lowers interest rate, firms
borrow more and invest more. Higher interest rates mean lessinvestment.

5.7.2. FISCALPOLICY
Fiscal policy involves the use of government spending, taxation and borrowing to influence
both the pattern of economic activity and also the level and growth of aggregate demand, output
and employment. It is important to realize that changes in fiscal policy affect both aggregate
demand (AD) and aggregate supply (AS). Most governments use fiscal policy to promote stable
and sustainable growth while pursuing its income redistribution effect to reduce poverty. Fiscal
policy therefore plays an important role in influencing the behavior of the economy as monetary
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policy does. The choice of the government fiscal policy can have both short and long term
influences. The most important tools of implementing the government fiscal policy are taxes,
expenditure and publicdebt.

Traditionally fiscal policy has been seen as an instrument of demand management. This means
that changes in government spending, direct and indirect taxation and the budget balance can be
used to help smooth out some of the volatility of real national output particularly when the
economy has experienced an external shock.

Fiscal policy decisions have a widespread effect on the everyday decisions and behavior of
individual households and businesses. Thus, it is mainly used to achieve internal balance, by
adjusting aggregate demand to available supply. It also promotes external balance by ensuring
sustainable current account balance and by reducing risk of external crisis. In general, it helps
promote economic growth through more and better education and health care.

MAJOR FUNCTIONS OF FISCAL POLICY

Allocation: The first major function of fiscal policy is to determine exactly how funds will be
allocated. This is closely related to the issues of taxation and spending, because the allocation of
funds depends upon the collection of taxes and the government using that revenue for specific
purposes. The national budget determines how funds are allocated. This means that a specific
amount of funds is set aside for purposes specifically laid out by the government. The budget
allocation is done on the basis of aggregated development objectives such as recurrent vs.
capital expenditures or sectorial allocation (economic and social developments).
Distribution: The distribution functions of the fiscal policy are implemented mainly through
progressive taxation and targeted budget subsidy. Virtually allocation determines how much
will be set aside and for what purpose, the distribution function of fiscal policy is to determine
more specifically how those funds will be distributed throughout each segment of the economy.
For instance, the government might apportion a share of its budget toward social welfare
programs, such as food security and asset building for the most vulnerable and disadvantaged in
society. It might also allocate for low-cost housing construction and masstransportation.

Stabilization: Stabilization is another important function of fiscal policy in that the purpose of
budgeting is to provide stable economic growth. Government expenditure needs particularly in
developing countries such as Ethiopia are unlimited. But its source of financing is limited. Thus
without some restraints on spending or limiting the level of expenditure with available financial
resources the economic growth of the nation could become unstable, creating imbalances in
external sector as well as resulting in high prices.
Development: The fourth and most important function of fiscal policy is that of promoting
development. Development seems to indicate economic growth, and that is, in fact, its overall
purpose. However, fiscal policy is far more complicated than determining how much the
government will tax citizens in a given year and then determining how that money will be spent.
True economic growth occurs when various projects are financed and carried out using
budgetary finance. This stems from the belief that the private sector cannot grow the economy
by itself. Instead, government input and influence are needed. The government is responsible
for providing public goods, reduce externalities and correct market distortions in order to pave
the way for private sector.
The underlying principles of the tax policies in Ethiopia are as follows:
 To introduce taxes that enhance economic growth, broaden the tax base and
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 increase governmentrevenue;
 To introduce taxes that are helpful to implement social policies that discourage
consumption of substances that are hazardous to health and socialproblems;
 To introduce tax system that accelerate industrial growth and achieve
transformation of the country and to improve foreign exchange earnings, as well
as create conducive environment for domestic products to become competitive
in the international commoditymarkets;
 To ensure modern and efficient tax system that supports the economicdevelopment;
 To make the tax system fair and equitable;
 To minimize the damage that may be caused by avoidance and evasion of tax;and
 To promote a tax system that enhances saving andinvestment.

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